- Developed under the assumption that investments contain two types of risk:
--- Systematic risk: Risk that cannot be diversified away
--- Unsystematic risk: Risk specific to individual assets which can be diversified away

Steps to Calculate the Equity Cost of Capital:

1. Calculate Rf, the risk-free rate of capital, often assumed to be a 10-year Government bond
2. Calculate a premium to be paid by investing in the more volatile equity market (Rm - Rf)
3. Apply a beta, B, to the market risk premium, which measures how the stock fluctuates compared to the market
--- If B < 1, the stock price is less volatile than the market
--- If B > 1, the stock is more volatile than the market
4. Final equation for the cost of equity: Re = Rf + (Rm - Rf) x B

In the previous lesson we examined the formula for the Weighted Average Cost of Capital, or WACC. We then focused on the hardest value in this formula to calculate, which is often the cost of equity. In this lesson, we're going to use the Capital Asset Pricing Model to calculate the cost of equity, and separately examine ways that analysts often get around using WACC by implenting IRR calculations when valuing a business. The Capital Asset Pricing Model is developed under the assumption that investments contain two types of risks. The first type of risk is systematic risk, which is risk that cannot be diversified away. This is risk from events such as recessions, interest rate hikes, etc that effect the whole market. The second type of risk is unsystematic risk, which is risk specific to individual investments, which can be diversified away. An example of unsystematic risk might be a rise in oil prices that affect a company like Exxon Mobil. To account for both types of risk, the CAPM Model adopts the following approach to calculating the cost of capital. It starts with the risk-free rate of return, which is assumed typically to be a 10-year government bond. This is essentially the systematic risk. It then calculates a premium to be paid by investing in the equity markets, and this additional premium is the expected return of the market, rM, minus the risk-free rate of capital, rF.

In step three, we apply a value called beta, to the market risk premium, and beta measures how the stock in question fluctuates compared to the market. If beta is less than one, this means that the stock price is less volatile than the market. And this would typically be the case for energy or water utilities, which are pretty stable businesses. If beta is greater than one, then the stock is more volatile than the market, and this would certainly be the case for a lot of technology or biotechnology stocks. Putting these steps together, we can develop a formula for the cost of equity, which is equal to the risk-free rate plus the market risk premium, which is the expected market return, minus the risk-free rate, multiplied by beta.

It's important to stress at this point that the Capital Asset Pricing Model is quite controversial. It's not used by every analyst, and it does have some obvious weaknesses. For example, the risk-free rate is based on long-term government bonds, which can of course change in price. What's more, the expected market return can also change very frequently. In the following chart, I showed the one year return on the S and P 500 since 2012, and as you can see, the one year return fluctuates dramatically from just under 30% to minus 7.5%.

As a consequence, many analysts have chosen to ignore the CAPM Model and focus instead on the Internal Rate of Return. As you may have seen in previous courses, the internal rate of return is an effective way of understanding the return on any money invested in either an asset or a company, and in the coming lessons I'll show you in our Excel model how to use both the Capital Asset Pricing Model and Internal Rate of Return when valuing a business.